Press Room

8 Jul 2024

Cryptoassets and the rise of the tax calculators – Ben Lee

Digital Assets Partner, Ben Lee, explains why crypto tax calculators cannot be relied on exclusively to arrive at an accurate tax figure, in Tax Journal.

Ben’s article was published in Tax Journal, 27 June 2024.

Cryptoassets. Opinions on the asset class are mixed, but two things are certain: they are here to stay, and they come bearing tax obligations.

Calculating a tax position is not simple for most investors. An entire industry of online-based crypto tax calculators has emerged to assist advisors in interpreting the data and applying the relevant tax legislation of any number of jurisdictions. Crypto-tax calculators are useful tools, but they cannot yet be relied upon in their entirety. This article explains why.

The basics of cryptoasset taxation

The default position for transactions involving buying and selling cryptoassets is of an investment nature.

HMRC’s Cryptoasset Manual states that only in exceptional circumstances would HMRC expect individuals to buy and sell cryptoassets with such frequency, level of organisation and sophistication that the activity amounts to a financial trade itself (CRYPTO20250).

Cryptoasset activity, therefore, falls within the scope of CGT, with the need arising to calculate gains or losses when cryptoassets are disposed of. Broadly, this includes:

  • selling cryptoassets for money;
  • exchanging cryptoassets for different cryptoassets;
  • using cryptoassets to pay for services; and
  • gifting cryptoassets to another individual (unless spouse or civil partner).

Cryptoassets are pooled under TCGA 1992 s 104. A separate pool will exist for each type of cryptoasset, increasing with acquisitions and decreasing with disposals. The exception to this rule is non-fungible tokens (NFTs) that are separately identifiable and are not pooled.

Cryptoassets received by ‘staking’ assets (for example, committing the assets as collateral to validate transactions on the network or providing assets to liquidity pools) are taxable as income (miscellaneous income) at the pound sterling value at the time of receipt. There may be further CGT implications on the disposal of these tokens.

The difficulties of taxing cryptoassets

At first glance, it would appear that taxing cryptoassets is not a complicated matter, as most activity falls within widely understood areas of legislation. However, there are areas where the principles of taxation to be applied to cryptoassets is not immediately obvious. A clear example of this is transactions undertaken in decentralised finance (DeFi). DeFi mimics traditional finance systems, allowing individuals to collateralise their cryptoassets for loans, provide liquidity to decentralised exchanges and many other activities.

HMRC was the second tax authority to provide extensive guidance on DeFi (see CRYPTO60000 onwards), hoping to provide more certainty to taxpayers operating in this space. However, the guidance highlighted the need to understand what is happening with assets provided to platforms at a much deeper level to understand whether there has been a disposal of assets to the platform. Is the platform rehypothecating assets? What do the terms and conditions say? Is the return received on collateralised assets income or capital? Does Marren v Ingles [1980] STC 500 apply to capital receipts? (These issues are reviewed in ‘CRYPTO60000: ‘DeFi’nitive guidance from HMRC?’ (Sam Inkersole), Tax Journal, 10 March 2022.)

Despite HMRC’s call for evidence on DeFi taxation in July 2022, and a further consultation that ran from April 2023 to June 2023 considering options to simplify the requirement to capture numerous data points for the user, and provide further clarity as to a taxpayer’s position, there have been no further updates. The taxpayer must assess the activity undertaken in DeFi to determine the tax treatment.

We have also established that cryptoassets are pooled in the same manner as shares. This is logical given the fungibility of certain cryptoassets, and the ease at which cryptoassets can be bought and sold on exchanges. There are, however, stark contrasts between asset classes. Share brokers typically provide an annual statement outlining a portfolio’s income and capital gains for tax purposes. Cryptoasset exchanges do not.

High volumes of share dealings may indicate a trade, negating the requirement to pool under s 104. High volumes of cryptoasset transactions are common and easily achieved. Individuals heavily involved in crypto can easily manage 5,000 to 10,000 transactions a year; given the digital nature of these assets, tech-savvy individuals can implement bots for various purposes (e.g. arbitrage bots that make automated trades based on differing prices offered between exchanges). These bots can execute over one million transactions a year. At this point, Microsoft Excel is really going to struggle, even if taxpayers have kept a full record of the transactions they have undertaken throughout the year (unfortunately, many don’t).

The rise of tax calculators

Cryptoassets exist on blockchains, which (largely) operate as public ledgers. They can be interrogated using explorers, but tracing an individual’s trading history using these methods would be arduous. The last five years have seen a rise in online crypto tax calculators, allowing individuals to keep track of their cryptoassets and the gains or losses attributable to their trades.

Many platforms offer free accounts but require a payment (based on the number of transactions a user has undertaken to date, not in the specific tax year) to produce a tax report.

To set up an account, a user would be required to link any cryptoasset exchanges they have used (typically via APIs) and provide any details of wallets they have used personally. The software will then acquire the relevant trading history from the exchange and scrape any on-chain information (i.e. the data on the blockchain) relating to non-custodial wallets to build a picture of an individual’s cryptoasset portfolio.

The software will then pull in relevant pricing information relating to acquisitions and disposals and perform the necessary pooling calculations so that when a cryptoasset is partially or completely disposed of, it will calculate the gain or loss on disposal accordingly.

Where new cryptoassets are received outside of acquisitions, the software will record these assets as rewards and treat them as subject to income tax.

Typically, if the software does not support a certain blockchain, it is possible to upload a CSV of transactions to keep records complete.

Where software struggles

There are several reasons why software may attribute
the incorrect base cost to cryptoassets, or have difficulty recognising the base cost for new assets. The list below is a non-exhaustive set of examples of issues that may occur within a dataset.

Incomplete records: The software considers any transfer of assets to a wallet outside of those it has recognised as belonging to the individual as a disposal. Individuals operating in this space are likely to have wallets that they have forgotten about, such as those set up for a particular token or one-time use. If the data set is incomplete, the tax position will be incorrect.

Airdrops: An ‘airdrop’ is the term given to the receipt of cryptoassets as part of a marketing or advertising campaign or to reward community loyalty. Certain projects have rewarded holders of tokens or NFTs with alternative tokens. Income tax is not always applicable if the recipient has performed no services to receive the airdropped tokens. Software is generally good at automatically detecting well-known airdrops (for example, Apecoin, which was airdropped to Bored Ape Yacht Club NFT holders). Different software may provide different base costs for these assets, and it is important to check that the treatment agrees with how the tokens were received.

If a smart contract mints the tokens into one wallet address and distributes them to recipients from that address, it may
be possible to argue that the acquisition cost of the tokens is market value at the time of receipt if it constitutes a ‘bargain made otherwise at arm’s length’.

However, if the smart contract distributes tokens directly to the recipient’s wallet, there is no corresponding disposal; the market value rule is disapplied, and the actual amount paid for the token becomes the acquisition cost (i.e. £nil).

NFT base costs: NFTs can be purchased via online marketplaces. To acquire an NFT, the user will send cryptoassets to a smart contract and receive the NFT. This is unlikely to be instantaneous, and software regularly does not assign the value spent on acquisition to the base cost of the NFT purchased.

It is also possible to bulk-buy NFTs in a single transaction. The NFTs will possess differing characteristics; the base cost for each individual NFT acquired will vary based on the ‘uniqueness’ of these characteristics (remember NFTs are not pooled). On the eventual sale of an individual NFT from this purchase, the software will either not allocate any base cost
to an individual NFT or apportion base cost from the bulk purchase equally across the NFTs purchased.

Collapsed exchanges: 2022 was a bad year for cryptocurrency. A series of unfortunate events had an unfortunate effect on the market, heralding a new crypto winter. One such event was the collapse of the third-largest cryptocurrency exchange,

FTX. Upon filing for bankruptcy in November 2022, users found themselves locked out of the exchange, and the FTX API ceased functioning. Individuals could not retrieve their assets or any transactional data that may have been required for tax purposes. This is not uncommon behaviour for exchanges. Individuals who entered the space early may have used exchanges that no longer exist and be missing entire base cost data for their assets.

Whilst this presents difficulties when establishing a complete data set for tax purposes, there are further difficulties presented by collapsed exchanges. It may be prudent to consider a negligible value claim for irrecoverable assets. Cryptoassets are pooled and, as a result, a negligible value claim would need to be made in respect of the whole pool,
not individual tokens. This may present difficulties where an individual holds bitcoin on multiple exchanges, and one of the exchanges fails.

Burn-to-mint: Token burning is the act of removing cryptoassets from circulation by sending them to a wallet address that cannot be used for transactions other than receiving the cryptoassets. In some instances, tokens may
be sent to a burning wallet to receive an NFT or as part of a blockchain upgrade (i.e. hard fork). The sender would then receive cryptoassets in return at a later date, but the software cannot link the transactions together, causing the disposal of the initial cryptoasset and recognising a new cryptoasset as a deposit. This can often cause issues with the correct value being assigned to the new asset.

Locked tokens: This is typically a symptom of over-the- counter trades for low-market cap assets, whereby cryptoassets are transferred to a wallet in exchange for another cryptoasset. These cryptoassets are locked until a differing cryptoasset is returned to the original sender. The disposal of the original asset is likely to be recorded correctly, but there may be difficulties correctly recording the value of the new asset received where it is not listed on exchanges.

Liquidity pooling: Individuals can contribute to liquidity pools by sending pairs of cryptoassets to a decentralised pool that supports a decentralised exchange. For example, if we send a pair of cryptoassets in equal proportions to a liquidity pool and are returned liquidity pool tokens to represent the holding, the software is unlikely to allocate a base cost to the liquidity pool tokens. When these tokens are then exchanged in return for the original assets, the software will recognise an exaggerated gain as no base cost exists on the token disposed of.

Final thoughts

These are just some of the examples that highlight the requirement to understand the data when considering the gains, losses, or income derived from cryptoasset transactions. Whilst crypto tax calculators are a useful tool in any adviser’s utility belt, they fail to perform the task fully and the data often requires numerous manual adjustments to arrive at an accurate tax figure. A clear understanding of the underlying data is required.Cryptoassets and the rise of the tax calculators – Ben Lee

Ben Lee

Ben is a Partner within Andersen’s crypto team and is a highly experienced and accomplished Chartered Accountant and Chartered Tax Advisor. With a strong focus on digital assets, Ben is committed to providing individuals and companies with expert accounting and taxation services in this rapidly evolving landscape.

Email: Ben Lee